Analyze Your Personal Risk Tolerance
Your risk tolerance is your ability or willingness to endure declines in the
value of your investments while you wait for them to return a profit that
will help you meet your investment goal. Some investors find it easy to
ignore market fluctuations and to focus on their long-term investing
goals. Others become anxious when their portfolio declines in value by
even a small percentage. Your emotional makeup plays a significant role in
how you allocate your investment assets.
Consider how you would react if one of your investments suffered a sudden 20-25%
decline. If the possibility of such a loss would keep you awake at night,
you might choose a relatively conservative asset mix. However, in doing
so, you run the risk that inflation will erode a greater percentage of
your returns.
Keep in mind, too, that all investments—even "super-safe" choices
like bank accounts or money market funds—are subject to some type of
risk.
MARKET TIMING
When it comes time to invest your money, you may hesitate out of fear that your
investment will lose value. You may wonder: Are stocks
at an all-time high? Are bonds
too expensive relative to other investment alternatives?
You may think that the way to avoid market losses and maximize gains is to use
market timing—a strategy in which you try to buy before the
market goes up and sell before it declines. Here's how market timers
operate:
- They wait until stock or bond prices seem to be at an appropriate level
relative to various historical measures—or until an expert declares
stocks or bonds to be a "good deal." Then they rush to make
substantial investments all at once.
- When prices reach high valuation levels, as measured by historical benchmarks
or expert opinion, market timers rush to sell all at once.
Unfortunately, few investors can predict with any degree of accuracy when, and how much,
the securities markets will rise and fall. (Even economists and other
financial experts cannot accurately forecast market movements
consistently.) As a result, many investors jump into the market after a
sustained rally, or they panic and sell at a loss when prices fall.
What makes market timing even more difficult is that stock and bond market
rallies tend to occur in spurts. Market timers are at high risk of missing
those rallies. For example, according to a study conducted at the
University of Michigan, 95% of the market gains between 1963 and 1993
stemmed from the best 1.2% of trading days. The implication is clear: Over
time, being out of the market even briefly can significantly diminish an
investor's returns.
This natural unpredictability, due to the basic volatility of the market, is
enough to make market timing a difficult task for even the most
experienced investor. What all investors must realize is that financial
markets simply don't move in reliably predictable patterns. Yes, they move
up and down. But market cycles aren't as regular as clockwork, and there
is no surefire system to profit from "timing" these movements.
However, a well-organized investor can still find ways to make market volatility
work for them without the hassle of trying to determine the exact time to
buy and sell. This can be accomplished through the use of a basic
investment strategy known as dollar-cost averaging.
DOLLAR-COST AVERAGING
Whether you're new to investing or a sophisticated investor, you may want to
use dollar-cost averaging, a basic strategy favored by many
financial experts.
The approach takes advantage of Wall Street's only certainty: Bond and
stock prices fluctuate. With dollar-cost averaging, you make the
market's natural volatility work for you by lowering the average
price you paid for your shares.
All you do is invest equal amounts in a security at regular intervals.
Because the amount you invest remains constant, you are able to buy more
shares when the price is low and fewer shares at a higher price. As
a result, the average cost per share—and the amount you paid for
the shares—will always be lower than the average market price of
the shares. There's no magic to it—just simple
arithmetic.
Dollar-cost averaging can help you:
- Reduce Your Investment Risk. The strategy
prevents you from committing substantial assets at the wrong time.
Suppose you have $10,000 to invest in the stock market. If you
invest the entire amount at once, you risk a large loss. For
example: if you had invested $10,000 at the start of 1973, it would
have dwindled to $6,270 by year-end 1974—a 37% decline. You would
then have waited two years for your investment to recover its
original value.
- Invest Regularly. Many mutual fund companies offer an automatic
program to investors at no charge. Often it's as easy as setting
up regular transfers from your bank account or money market fund
account. In addition to providing your investment program a
measure of discipline, you'll protect yourself from your
emotions—and the natural tendency to cease investing—in a
weak market.
Keep in mind that dollar-cost averaging does not ensure you a profit or
protect you against a loss in declining markets. You should also
consider your ability to invest continuously through periods when
the market is down.
Fixed Investment |
Share Price |
Shares Acquired |
Fixed Invest-ment |
Share Price |
Shares Acquired |
Fixed Investment |
Share Price |
Shares Acquired |
$400 |
$5 |
80 |
$400 |
$16 |
25 |
$400 |
$10 |
40 |
$400 |
$8 |
50 |
$400 |
$10 |
40 |
$400 |
$8 |
50 |
$400 |
$10 |
40 |
$400 |
$8 |
50 |
$400 |
$5 |
80 |
$400 |
$10 |
40 |
$400 |
$8 |
50 |
$400 |
$8 |
50 |
$400 |
$16 |
25 |
$400 |
$5 |
80 |
$400 |
$10 |
40 |
Total: $2,000 |
$49 |
235 |
Total: $2,000 |
$47 |
245 |
Total: $2,000 |
$41 |
260 |
Average share price:
$9.80 ($49 ÷ 5)
Average share cost for you:
$8.51 ($2,000 ÷ 235) |
Average share price:
$9.40 ($47 ÷ 5)
Average share cost for you:
$8.16 ($2,000 ÷ 245) |
Average share price:
$8.20 ($41 ÷ 5)
Average share cost for you:
$7.69 ($2,000 ÷ 260) |
Stocks are defined as shares of ownership--also known as equities—that are bought for the potential increase in value, with less reliance on a return through dividends.
Bonds are defined as formal certificates of debt, usually issued by corporations or the government.
|
